Prospect Theory and the Newsvendor Problem with Mental Accounting
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ISSN: 1004-3756 (paper), 1861-9576 (online) CN 11-2983/N
Prospect Theory and the Newsvendor Problem with Mental Accounting Bojun Gu,a Xiang Zhangb, c a School
of Economics and Management, Zhejiang Ocean University, Zhoushan 316022, China [email protected] b School of Management and Economics, Beijing Institute of Technology, Beijing 100081, China c Sustainable Development Research Institute for Economy and Society of Beijing, Beijing 100081, China [email protected] ()
Abstract. The manner in which economic outcomes are coded in a value function is critical because it
has substantial influence on the evaluation of risky choices. In this paper, we formulate multiple mental accounts in a nonlinear value function and propose a newsvendor problem with mental accounting to predict and explain pull-to-center phenomenon. We show that the distinctive predictions of the proposed model come from the value function with mental accounting. We identify the individual and combined effects of loss aversion, risk aversion, and risk seeking on shaping newsvendor ordering behavior. Our work demonstrates that prospect theory can explain the decision bias and ordering behavior observed in newsvendor experiments. We also provide some additional insights to explain the studies in the literature. Keywords: Prospect theory, mental accounting, newsvendor problem, decision bias, pull-to-center phe-
nomenon
1. Introduction Newsvendor problem has been widely used to investigate decision behavior. Readers can see Qin et al. (2011) for a review of the traditional newsvendor problem. For more than a decade, researchers have observed that newsvendor ordering decisions systematically deviate from the prediction of expected profit maximization. One of the interesting observations for newsvendor problem is pull-to-center (PTC) phenomenon. Suppose the product incurs purchase cost c and sells at price p, p > c. The profit-maximizing quantity for a newsvendor is the optimal rational choice or normative order quantity. The PTC phenomenon refers to the effect that, compared to normative order quantity, the subjects consistently overorder in the low-profit condition (i.e., c/p > 1/2) and underorder in the high-profit condition (i.e., c/p < 1/2). This is interesting because the phenomenon has been repeatedly reported in experiments (see Bolton and Katok (2008), Bos-
tian et al. (2008), Ho et al. (2010), Kremer et al. (2010), Becker-Peth et al. (2013), Davis et al. (2014), Rudi and Drake (2014), Schultz et al. (2018)) since it was first observed in a study by Schweitzer and Cachon (2000). There also is significant interest in investigating why subjects present such decision bias in the newsvendor context. More importantly, there are multiple explanations of the root reason for the occurrence of the PTC phenomenon. Prospect theory (PT) (Kahneman and Tversky 1979, Tversky and Kahneman 1992), which depicts that people code and evaluate economic outcomes as gains or losses relative to a reference point and are more sensitive to the losses than equivalent gains, h
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